In times of crisis, the US Federal Reserve employs monetary-policy tools to help stabilize the situation. But in the past few years, there’s been some public speculation as to whether it has lost a crucial tool and, by extension, its control over short-term interest rates. “As Fed Loses Control of Overnight Rates, Blame Shifts to T-Bills,” blared a Bloomberg headline in 2018. The article quoted Credit Suisse Group AG analyst Zoltan Pozsar as saying, “Only the US Treasury can fix this, not the Fed.”
The concern that the Fed has lost control is overblown, according to Chicago Booth’s Quentin Vandeweyer. It can still move short-term rates, his research suggests, but it does so in a new way because of regulatory changes.
Traditionally, to influence monetary conditions, the Fed changes the reserves available to banks. To push rates up, it reduces reserves; to suppress them, it does the opposite, as it has when financial markets need liquidity, such as during a crisis.
Because only traditional banks have reserves with the Fed, it has relied on them to act as mediators to reach the broader economy. When the Fed has increased reserves, thus growing the money supply available to banks, those banks have done deals in the repo market, where they trade with money market funds, spreading liquidity further into the economy and broadcasting the level of interest rates.
However, since the 2008–09 financial crisis, there have been signs that something has changed. In 2018, for example, short-term rates moved sharply up, to the limit of what the Fed had targeted. “There was a big puzzle as to why this was the case and whether this meant the Fed had lost control more broadly,” Vandeweyer says.
Regulatory changes stemming from the 2009 international accord Basel III and the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act made repo-market deals less profitable for banks, which could have stopped them from acting as intermediaries, he finds. With liquidity essentially stuck at banks and not reaching the rest of the market, the supply of Treasury bills, rather than reserves, became the primary driver of short-term rates. Money market funds are large and important participants in the market, but they can’t access Fed reserves as banks do, so instead hold T-bills as short-term assets, says Vandeweyer, who analyzed data including the share of available T-bills held by money market funds.
However, the Fed appears to have found two ways around this problem. One way prevents short-term rates from falling too low, and the other prevents them from rising too high.
To establish a floor, the central bank in 2014 created an asset that money market funds can hold directly at the Fed. Through the Fed’s reverse-repo facility, money market funds can deposit at the Fed, but they receive a lower rate than the Fed pays banks on their deposits. In this way, the Fed is able to bypass banks and provide liquidity to money market funds and prevent rates from falling below this threshold. As money market funds have the option to lend to the Fed at this rate, they will never accept a lower rate from other borrowers, effectively setting a lower bound for short-term rates.
But at one point in 2018, the Trump administration increased the supply of T-bills, which sent short-term rates skyward, surprising the Fed. After that, to control the upper bound of rates, the Fed directly changed the amount it pays to banks on their reserves, which in turn affected rates on most other assets.
After March 2020, a similar situation occurred when the Treasury increased the supply of T-bills to finance the government’s stimulus spending. But a year later, the situation reversed and the supply of T-bills grew sparse. In late April, T-bill rates turned negative, and the Fed seemed poised to once again rely on its reverse-repo facility to influence short-term rates. Vandeweyer predicts that it will eventually have to remove its self-imposed cap on the quantity of assets that money market funds can place at the Fed.